Rent review update – leases in transition?

Citation

Dowden, M. (2010), "Rent review update – leases in transition?", Journal of Property Investment & Finance, Vol. 28 No. 2. https://doi.org/10.1108/jpif.2010.11228bab.001

Rent review update – leases in transition?

Article Type: Law briefing From: Journal of Property Investment & Finance, Volume 28, Issue 2

Introduction

2009 was a relatively quiet year for rent review cases as economic pressures focused attention on insolvency or tenant retention. However, the year did see the stirrings of a significant debate on the continuing relevance and suitability of key “institutional” assumptions and their possible impact on rent review. The shortening of lease terms evidenced since the mid 1990s by British Property Federation (BPF)/ Investment Property Databank (IPD) annual reports coincided with a marked trend in case law that leaned against imposing expensive obligations on tenants unless there was very clear wording to require that imposition. The Code for Commercial Leases, reissued in 2007, confirmed the recommendation that landlords should, generally, be responsible for major capital expenditure and uninsured risks. Commercial leases have, in effect, moved towards the status of “contracts to occupy”.

Nonetheless, “institutional” lease assumptions still dominate the drafting of leases in the UK. The landlord’s objective is to achieve a rent that is “clear” of deductions and excludes all costs arising from the tenant’s use of the building. Any departure from this convention can adversely affect investment value because residual costs to the landlord are generally deducted to calculate the net income before capitalisation. “Holes” in leases give rise to an immediate reduction in capital value, as does any prospect of a shortfall, which can necessitate an adjustment to the capitalisation yield.

Significant developments in environmental policy now threaten to expose the tensions inherent in the quest for a clear lease. It is trite law that the inclusion of “onerous” obligations enables the tenant to argue for a discount at rent review. In Norwich Union Life Insurance Society vs British Railways Board (1987) 283 EG 846, for instance, a rent review surveyor discounted the open market rent by 27.5 percent to reflect the onerous nature of the obligation “to keep the demised premises in good and substantial repair and condition and when necessary to rebuild, reconstruct or replace the same”. This was deemed particularly onerous because the 150-year term meant that it was quite likely that the demised premises would require a degree of rebuilding at some point. The impending question for landlords and tenants in 2010 is how the CRC Energy Efficiency Scheme (CRC) will impact on rent reviews.

What is CRC?

The CRC is due to begin in April 2010 and will be based on electricity consumption in 2008. Those public and private organisations whose annual electricity consumption from half-hourly meters exceeded 6,000MWh in 2008 will qualify for the scheme. Companies in the same group will comprise a single entity the ultimate parent will be the qualifying participant unless a subsidiary that qualifies in its own right elects to be treated separately.

If it qualifies, the organisation must buy allowances (tonnes of CO₂). Initially, these will be set at a fixed price of £12 per tonne, but they will eventually be auctioned or traded via a secondary market. Newly announced rules render the first year of the scheme a “dry run”, incurring no payments.

Allowances will be bought or surrendered annually, depending on consumption. Organisations will recoup a recycling payment based on their performance in a league table.

The CRC does not explicitly cater for landlord and tenant situations. In many cases, the landlord is likely to be the “CRC entity” required to purchase allowances. However, energy consumption, the cost of the scheme and recovery of “recycling payments”, depend on tenant behaviour. Landlords’ attention has therefore tended to focus on lease drafting that will allow them to pass on to tenants all costs arising from CRC.

CRC is an intensely bureaucratic process. Any attempt to pass the initial cost of allowances on to tenants, particularly in a diverse portfolio, significantly increases the risk of expensive dispute. The CRC entity is the highest UK parent company in a group. Consequently, it is not possible to avoid the CRC, or to minimise the scope for dispute, by vesting single properties or particular categories of building in separate companies.

Lease provisions are beginning to circulate, frequently empowering the landlord to allocate costs to buildings within its portfolio on a “fair and reasonable basis” (lawyer speak for “we really have no idea how this will work in practice”). A calculation by reference to floor area might be ostensibly fair and simple to operate, but does not distinguish between types of building or intensity of energy use. A bakery or manufacturing unit might occupy the same amount of floorspace as an unheated warehouse or high class offices, but their energy use would be radically different. A more precise allocation would require the installation of separate meters – itself a potentially significant up front cost for landlords.

Tenant amendments may require the landlord to take into account the “energy efficiency” of the relevant building as compared with any other building for which the landlord must purchase allowances. However, “energy efficiency” requires further definition. It might relate to the “asset rating” evidenced by an Energy Performance Certificate (how efficient the building could be as a matter of design and construction), or to the “operational efficiency” assessed by comparing an assumed level of consumption (based on the asset rating) with actual usage. A tenant has no influence or control over the asset rating, but a great deal over the operational rating.

Additional allowances

If energy use exceeds initial allowances, a landlord seeking to pass on to tenants the cost of additional allowances might expect strenuous objections from those whose energy use remained within the original allowances, arguing that the additional costs should be borne by profligate tenants. Identifying those tenants might be extremely difficult in a large portfolio, generating significant administrative cost and inconvenience in meeting tenant demands for information.

Tenants might also argue that if the landlord’s original estimate was incorrect then the cost of error ought to fall on the landlord. That cost might be exacerbated by the higher price of allowances on the secondary market producing a further tier of dispute if tenants challenge the cost of “emergency” purchases.

Commercial activity on the part of the landlord (including the acquisition of new properties not factored in when estimating energy use at the start of the scheme year) might itself necessitate additional allowances. Existing tenants would be likely to resist demand for further payments triggered by the landlord’s commercial decision, while tenants of the newly acquired property might find themselves for the first time dealing with a landlord subject to CRC and demanding previously unbudgeted payments.

Recycling payments – paying for improvements

Recycling payments are intended to incentivise CRC entities improve energy efficiency. If landlords require tenants to pay the up-front cost of allowances they can have no reasonable basis for retaining recycling payments for their own benefit. Tenants might also balk at a suggestion that the landlord should retain the payments to fund improvements. The principle underpinning service charge and other costs traditionally passed on to tenants is that the tenant can be called on to fund repair and maintenance, but not improvement.

However, in the hands of tenants recycling payments would be highly unlikely to meet the policy objectives of CRC, and would certainly not assist landlords to meet the demands of transition to a low carbon economy. Tenants, particularly those with relatively short terms, would have absolutely no obligation or incentive to use those payments to fund improvements to the landlord’s capital asset.

By contrast, in the hands of the landlord, recycling payments might be allied with a range of incentives and penalties (“green lease” issues) and legitimate service charge recovery to form part of a fund for the progressive renewal or improvement of plant, equipment and energy performance.

Faced with new costs, many landlords will adopt a “business as usual” approach and seek to pass them on to tenants. However CRC is a new and different type of cost, and calls for a rethink of traditional institutional assumptions. “Business as usual” would be likely to generate dispute, and to exacerbate the landlord’s risk that onerous terms would result in a significant discount at rent review.

However, institutional leases severely limit opportunities to improve existing commercial property stock and act as a barrier to achieving the CO₂ emission reductions necessary to meet national targets in the fight against global warming.

So-called green leases have been heralded as the solution, but little has been said about the potential effect on property values. Restrictions on the way in which companies use their operational property, or obligations that increase occupiers’ costs, will reduce rents and, in some cases, conflict with existing statutes. Mistakes will be costly to rectify.

The real issue – that traditional lease terms need to be revised - is being lost in all the smoke surrounding green leases.

Main problems

The principal problem concerns the apparent “split incentive” between landlords and tenants, where the party paying the bill is rarely the party that stands to benefit from voluntary improvements.

Although it is becoming easier to assess the cost of environmental improvements, the only sure way of measuring cost-effectiveness is by reference to operational cost savings, such as the more efficient use of energy. Herein lies the problem.

Typically, a self-contained property is let to a single tenant on a full repairing lease responsibility for the property is effectively devolved to the tenant for the term of that lease. Where a property is let to a number of tenants, those tenants typically contribute towards the landlord’s costs for the exterior, common parts and shared services by way of a service charge. Whether payment is made direct to the supplier or through the service charge, the tenants ultimately meet the cost of energy consumed in the building and will therefore benefit from any cost savings.

The difficulty is that the cost of achieving a noticeable reduction in CO₂ often has a payback period, which can dramatically exceed the term of the lease. As lease terms become shorter, it can be hard for tenants to justify the costs and, in the absence of any tangible financial advantage, it is equally difficult for landlords to justify contributions to improvement costs, even though they may be the ultimate beneficiaries at the reversion of the lease.

In the case of multilet buildings, the landlord can recover the cost of improvements from many tenants. There is, however, little incentive because the tenants will be the ones to benefit from reduced costs.

In short, the intransigent nature of the institutional lease structure discourages both sides from addressing environmental performance. A switch to green leases is not necessarily a panacea, but it is wrong to adhere to “business as usual”.

The sustainability agenda means that several previously uncontroversial lease terms have become untenable. Until they are addressed in all leases, they may cause problems both for landlords and tenants.

Of major concern to the tenant is the universal obligation to comply with all current and future legislation. Well-advised tenants will no longer accept such a provision because an ongoing programme of legislation will include obligations for retrospective improvements and will have less regard to affordability. Even where service charge provisions allow the recovery of statutory compliance costs, the RICS guidance note excludes improvements beyond “normal maintenance, repair or replacement”. This may preclude higher expenditure on greener services.

Further, a creative landlord that relies on tenants’ covenants to observe its general rules and regulations to impose sustainable building management systems may find its creativity challenged in court.

Most alterations are allowed with qualified consent, when it is deemed that the landlord cannot withhold consent unreasonably. In the absence of express provisions, the statutory deeming provisions may sit uncomfortably alongside a landlord’s attempt to impose more sustainable building practices or to prevent works that could undermine the environmental performance of the base build. Moreover, landlords that impose preconditions or restrictions on tenants’ alterations, thereby increasing costs or limiting usability, may find that the rent achieved on review is reduced.

Equally, the prohibition against structural works may severely constrain a tenant’s ability to achieve CO₂ reductions. Even if the parties agree that a building should be improved in ways that are unsupported by the lease, they should consider how such works should be treated at rent review and what the tenant’s reinstatement obligations will be at the end of the lease.

Statutory intervention may increase the tenant’s obligation to repair through the ongoing tightening of building regulations.

Judicial precedent often limits a tenant’s obligations according to the age, nature and condition of the premises. If, as is expected, obligations to undertake consequential improvements will increase with each revision of the building regulations, a tenant’s obligation to replace, say, a boiler may trigger a requirement to improve insulation at the same time. The tenant may be unable to discharge its repairing liabilities without generating a statutory liability to improve parts of the building fabric or services over which it has no control or from which it derives no discernable benefit.

Significant changes to conventional leasing custom will be needed. For some new buildings, green leases may eventually provide some of the answers.

Unintended consequences

Meanwhile, the property market is dominated by the institutional lease. Many standard lease provisions, which will almost certainly be carried forward into new leases at statutory renewal, could create a series of unintended consequences that may accelerate unwary tenants’ liabilities, while simultaneously undermining the value of some unlucky landlords’ investments.

Malcolm DowdenLexisPSL